Senate Releases Tax Bill: Here's How It Compares To Current Law & The House Plan

[UPDATE: This post was originally published prior to the passage of the Senate bill. That bill was amended as part of debate after this column was originally published and prior to its passage. This post has been updated to reflect those changes.]

What a week. Last Thursday, the House released its vision for tax reform, launching a flurry of analysis by the tax geeks, hand-wringing by the middle class, and defensive measures by the GOP.

Then, late last night, just as the House Ways and Means Committee culminated a four-day mark-up of HR 1 by voting to advance the bill along party lines, the Senate decided it was time to get in the mix by releasing its plan to revise the tax law.

There's a lot to take in, clearly. It was hard enough to fully grasp how current law compared to the House bill, but now we've got to layer on the Senate proposal, which varies from both current policy and the House proposal in several significant ways.

What follows is a summary of the opening week of "tax reform season,' with an item-by-item comparison of current law, the updated House proposal, and the newly-published Senate bill.

Let's get to it...

Individual Tax Rates

Current Law

Ordinary income -- items like salaries, interest income, and business income -- is subject to a seven-bracket progressive system. Those rates are 10%, 15%, 25%, 28%, 33%, 35% and a top rate of 39.6%.

House Bill

HR 1 proposed four brackets: 12%, 25%, 35% and 39.6%. Taxpayers earning more than $1 million (if single, $1.2 million if married) would also be required to "clawback" the benefit of the 12% bracket at a 39.6% rate, increasing their tax by the excess of the 39.6% rate over the 12% rate on the first $45,000 of income (if single) or $90,000 (if married). This amounts to an increase in tax of $12,420 for single taxpayers and $24,840 for married, and an effective top marginal rate of 45.6%.

Senate Bill

The Senate bill retains a seven-bracket systems, but lowers the rates to 10%, 12%, 22.5%, 25%, 32.5%, 35%, and a top rate of 38.5%. More importantly, in order to make the Senate bill comply with the Byrd Rule -- which requires that the tax bill not add to the deficit beyond the ten-year budget window -- EVERY. SINGLE. INDIVIDUAL. TAX CHANGE. in the Senate bill will EXPIRE ON DECEMBER 31, 2025. Everything. The rate changes. The new child tax credit. The eliminated deduction. They are all stated to return to current law when the clock strikes midnight on New Year's Eve of 2025.

Here is a comparison of thee three possibilities, first, for single taxpayers:

Income Level

Current Rate

House Rate

Senate Rate

$0 - $9,525

10%

12%

10%

$9,525 - $38,700

15%

12%

12%

$38,700-$45,000

25%

12%

22.5%

$45,000-$60,000

25%

25%

22.5%

$60,000 - $93,700

25%

25%

25%

$93,700-$170,000

28%

25%

25%

$170,000-$195,450

28%

25%

32.5%

$195,450 - $200,000

33%

25%

32.5%

$200,000 - $424,950

33%

35%

35%

$424,950-$426,700

35%

35%

35%

$426,700 - $500,000

39.6%

35%

35%

> $500,000

39.6%

39.6%

38.5%

And here are the rates for married taxpayers:

Income Level

Current Rate

House Rate

Senate Rate

$0 - $19,050

10%

12%

10%

$19,050-$77,400

15%

12%

12%

$77,400-$90,000

25%

12%

22.5%

$90,000 - $120,000

25%

25%

22.5%

$120,000 - $156,150

25%

25%

25%

$156,150-$237,950

28%

25%

25%

$237,950-$260,000

33%

25%

25%

$260,000-$290,000

33%

35%

25%

$290,000 - $390,000

33%

35%

32.5%

$390,000 - $424,950

33%

35%

35%

$424,950-$480,050

35%

35%

35%

$480,050-$1,000,000

39.6%

35%

35%

> $1,000,000

39.6%

39.6%

38.5%

Observation:

It's a touch funny that Senate Republicans, who have long embraced the misguided notion that fewer brackets equates to a significant shift towards simplicity, chose to retain seven brackets. You will also note that relative to the House bill, the Senate proposal would force some lower-income ($38,700 - $45,000) and middle-income ($170,000-$200,000) taxpayers into higher marginal rates (12% versus 22.5% and 25% versus 32.5%, respectively). The same is true for married taxpayers on the low-income side, where those earning between $77,400 and $90,000 would pay a top rate of 12% under the House bill but 22.5% under the Senate proposal.

Like the House bill, the Senate proposal would adjust the brackets for inflation using chained CPI, rather than the standard CPI used under current law. This will cause taxpayers to accelerate through the brackets more quickly than under current law, likely leading to higher tax liabilities in later years of the ten-year budget window.

Capital Gain/Dividend Rates

Current Law

Under current law, those in the 10% and 15% brackets generally pay a 0% tax on gain from the sale of capital assets (things like corporate stock or your home) held longer than one year and qualified dividends. Above those income limits, taxpayers pay at a 15% rate until income reaches the start of the 39.6% bracket. For those in that top bracket, the rate on capital gains and dividends is 20%.

House Bill

HR 1 preserves the 0%, 15% and 20% brackets, and aligns those rates with the new brackets.

Senate Bill

The Senate proposal also preserves the same rates as under current law, and aligns those rates with the current law brackets, resulting in no change for taxpayers relative to current law.

First, single taxpayers:

Income Level

Old Rate

House Rate

Senate Rate

$0 - $9,525

0%

0%

0%

$9,525 - $38,700

0%

0%

0%

$38,700-$45,000

15%

15%

15%

$45,000 - $93,700

15%

15%

15%

$93,700-$195,450

15%

15%

15%

$195,450 - $200,000

15%

15%

15%

$200,000 - $424,950

15%

15%

15%

$424,950-$426,700

15%

20%

15%

$426,700 - $500,000

20%

20%

20%

> $500,000

20%

20%

20%

Then, married:

Income Level

Old Rate

House Rate

Senate Rate

$0 - $19,050

0%

0%

0%

$19,050-$77,400

0%

0%

0%

$77,400-$90,000

15%

15%

15%

$90,000 - $156,150

15%

15%

15%

$156,150-$237,950

15%

15%

15%

$237,950-$260,000

15%

15%

15%

$260,000 - $424,950

15%

15%

15%

$424,950-$480,050

15%

15%

15%

$480,050-$1,000,000

20%

20%

20%

> $1,000,000

20%

20%

20%

Observation

It's worth noting that the 3.8% net investment income tax that was added to the law as part of Obamacare remains in place. Thus, the top rate on long-term capital gains and dividends is more accurately represented as 23.8%.

Standard Deduction

Current Law

All taxpayers are entitled to deduct the greater of 1. the "standard deduction," or 2. the sum of itemized deductions, described below. Under current law, the standard deduction is $6,350 for single taxpayers and $12,700 for married taxpayers.

The Senate bill also doubles the standard deduction to $12,000 (if single, $24,000 if married).

By nearly doubling the standard deduction -- while at the same time eliminating many itemized deductions -- should the House or Senate bill become law, nearly 90% of taxpayers will claim the standard rather than itemize. This adds much needed simplicity for both taxpayers and preparers.

Personal Exemptions

Current Law

Each taxpayer is entitled to a $4,050 deduction for oneself, one's spouse, and any dependents.

House Bill

Personal exemptions would be eliminated. To soften the blow a bit, however, the Child Tax Credit will be increased from $1,000 to $1,600, though the refundable amount will not rise. In addition, a new $300 credit will be allowable for non-child dependents, and for the next five years, a "family flexibility" credit of $300 will be allowed for each spouse. In addition, the income limits at which a taxpayer starts to lose the child tax credit will be increased from $75,000 to $115,000 for single taxpayers and $110,000 to $230,000 for married taxpayers.

Senate Bill

The Senate bill would also eliminate personal exemptions. As was the case with HR 1, the Senate bill will attempt to ease the pain on families by increasing the Child Tax Credit to $2,000, a $400 increase over the House proposal but a $1,000 rise when compared to current law. The Senate proposal provides protection for the upper reaches of the middle class that is missing from the House bill, however, by increasing the income levels at which phase-out of the credit begins to $250,000 (if single, $500,000 if married). This will enable many more taxpayers to make up for lost personal exemptions with the enhanced CTC as compared to HR 1.

That's the good news; the bad news, however, is that unlike the House bill, the Senate does not offer any additional credit for a taxpayer, his or her spouse, and any non-dependent children. To illustrate, a married couple earning $100,000 and claiming three dependents (two children and one elderly parent), would be entitled to the following credits under the House and Senate bills:

House Bill

Senate Bill

Taxpayer

$300

none

Spouse

$300

none

Child 1

$1,600

$2,000

Child 2

$1,600

$2,000

Elderly Parent

$300

none

Observation

The table above will begin to equalize in 2023, when the $300 credit available under the House bill disappears. But until that time, families will be disadvantaged under the Senate proposal, as it is unlikely the small change in tax rates will make up for the loss of the $4,050 personal exemption.

In addition, because the Senate bill does not increase the refundable portion of the Child Tax Credit, but DOES substantially increase the income phase-out thresholds, a family of four with taxable income of $200,000 will enjoy a greater reduction in tax than a family of four with income of $30,000. That's not going to play well.

Itemized Deductions

Current Law

As stated above, each taxpayer is entitled to deduct the greater of: 1. a "standard deduction," or 2. the sum of itemized deductions. Itemized deductions include popular tax breaks such as the deductions for:

medical expenses

mortgage interest expense (on up to the first $1.1 million of acquisition and home equity debt)

personal casualty losses

real estate taxes

state and local income taxes

charitable contributions

unreimbursed employee expenses

tax preparation fees

The House and Senate Bills

Perhaps its best to compare the House and Senate bills treatment of itemized deductions in table form:

House Bill

Senate Bill

Medical expenses

eliminated

retained

State and local income taxes

eliminated

same as House

Property taxes

retained (up to $10,000)

retained (up to $10,000)

Mortgage interest

On up to $500,000 for new loans; no interest on second home, no interest on new home equity loans)

retained (but no deduction on home equity loans)

Personal casualty losses

eliminated (except for federal declared disaster areas)

same as House

Unreimbursed employee expenses

eliminated

eliminated

Tax preparation fees

elminated

eliminated

Observation

Both the House and Senate bills make it more difficult to sell your primary residence tax-free (by lengthening the ownership and use requirements of Section 121 -- which allows for an exclusion from gain of up to $250,000 (if single, $500,000 if married) -- from two out of five years to five out of eight years, and it makes for a nation full of unhappy realtors.

Other Popular Deductions

Current Law

In addition to itemized deductions, certain expenses are allowable on page one of an individual's tax return. These types of deductions are advantageous because a taxpayer will benefit from these expenses regardless of whether they itemize or claim the standard deduction. Included among these deductions are alimony payments, student loan interest, moving expenses, and a $250 deduction for teachers who purchase school supplies.

The House and Senate Bills

Again, let's look at this in table form:

House Bill

Senate Bill

Alimony deduction

eliminated

retained

Student loan interest

eliminated

retained

Educator deduction

eliminated

doubled to $500

Moving expenses

eliminated

eliminated

Commentary

I don't think I've EVER gotten so many panicked phone calls and emails from co-workers than when I wrote about the House bill's proposal to deny deductions for alimony payments. Rest easy people; the Senate has your back.

Pass-Through Business Income Tax Rates

Current Law

Taxpayers may operate a business in their individual capacity -- as a sole proprietorship -- or through a partnership or S corporation. The latter two business types do not pay tax at the business level; rather, the income of the business is allocated among the owners, who pay the corresponding tax on their individual returns. As a result, the individual owners are at the mercy of their respective individual rates, which as stated above, rise as high as 39.6%.

House Bill

HR 1 would apply a top rate of 25% on the income of S corporation shareholders, partners in partnerships, and sole proprietors. There are a number of caveats, however:

Only passive investors in a business are entitled to the 25% rate on all of their income from the business.

For any investor who "materially participates," the default setting is that only 30% of the income is attributable to the capital of the business and subject to the 25% rate. The remainder wold be taxed at individual rates as high as 39.6%, just like under current law.

Owners of service businesses -- like accountants and lawyers -- begin with the presumption that ZERO percent of their income is deserving of the 25% rate.

Senate Bill

The Senate bill takes a dramatically different approach in its effort to lower the tax burden on business owners. Under the Senate proposal, owners of sole proprietorships, S corporations and partnerships may take a deduction of up to 23% of their "qualified business income." This deduction is limited to 50% of the wages paid by the business, the theory being that this will discourage owners from foregoing wages in favor of flow-through income taxed at a lower rate.

To illustrate, assume A is the sole owner and employee of an S corporation that earns $500,000 during 2018. If the S corporation pays no wages to A, a deduction of 23% is not permitted, so A simply taxes the $500,000 of income at ordinary rates. If, however, the S corporation pays A an $80,000 salary, leaving $420,000 of flow-through income to A, A may claim a deduction equal to the LESSER OF:

$96,600 (23% of $420,000)

, or $40,000, which is 50% of the $80,000 of wages paid by the S corporation.

This provision has the effect of reducing the top rate on fl0w-through income from 38.5% to 30%.

The W-2 limitation does not apply if the owner's taxable income is less than $250,000 (if single, $500,000 if married). Also note, the 23% deduction is NOT available to owners of a "specified service business" -- such as accounting, engineering, or law -- unless the owner's income is less than $250,000 (if single, $500,000 if married).

Observation

The House and Senate bills make one thing clear: if you are going to provide preferential treatment to flow-through income, there needs to be safeguards in place to prevent taxpayers from gaming the system by foregoing wages (taxed at a high of 39.6%) in exchange for the beneficial treatment afforded the business income.

The House bill attempts to curb abuse by creating a default setting where the income of nonpassive owners is treated as being 70% attributable to services, and is thus taxable at ordinary rates, with only the remaining 30% of the income taxed at the preferential 25% rate. With a top ordinary rate of 39.6%, this creates a top effective rate on nonpassive owners of 35% ((39.6% * 70%) + (25% * 30%)). And because owners of service providers generally owe all of their business income to their efforts, rather than capital, abuses are prevented under the House bill by subjecting the entire amount of the income to ordinary rates.

The Senate bill takes a different tack, offering a 23% deduction, but only if wages are paid out (or in the case of a partnership, guaranteed payments). This creates a top effective rate on flow-though income of 30% (38.5% * (100% - 23%). Like the House, the Senate bestows no benefit on the owners of service businesses once they outgrow income thresholds ($250,000 if single, $500,000 if married).

Most interestingly, the Senate bill does not seem to differentiate between passive and nonpassive owners. This is a major criticism of the House bill -- which applies the 25% rate on ALL income earned by passive owners -- because it appears to provide incentive NOT to work. It appears -- though it is not entirely clear -- that passive and nonpassive owners will be treated the same under the Senate bill.

Individual Alternative Minimum Tax

Current Tax

After computing "regular" tax liability, taxpayers must compute an alternative liability using a parallel system, and then pay the greater of the two taxes.

House Bill

The alternative minimum tax is eliminated.

Senate Bill

The alternative minimum tax was preserved in a last minute deal, albeit with a larger exemption amount. In addition, the AMT is likely to ensnare far fewer taxpayers, because the primary AMT addback -- the state and local income tax deduction -- is being eliminated.

Estate Taxes

Current Law

A tax of 40% is imposed on the value of a taxpayer's assets in excess of $5.6 million ($11.2 million if married). The original GOP proposal would have eliminated the estate tax entirely.

House Bill

HR 1 immediate increases the exemption amount to over $10 million (over $22 million if married). After 2024, the estate tax would be eliminated entirely, while preserving a stepped-up fair market value basis to the heirs.

Senate Bill

The Senate proposal preserves the estate tax, but immediately increases the exemption amounts to over $10 million (if single, $22 million if married). Like the individual changes, this doubled estate tax exemption will disappear and reset to current law on December 31, 2025.

Observation

Refusing to repeal the estate tax may prove to be a nonstarter for many Senate Republicans, but it does generate much needed revenue that can be used to pay for tax cuts and preserve popular deductions like the one for medical expenses.

Corporate Tax Rates

Current Law

Corporate income is taxed at a top rate of 35%.

House Bill

Corporate income is taxed at a top rate of 20%.

Senate Bill

Corporate income is taxed at a top rate of 20%, but the rate is not dropped until 2019.

Observation

Many large business groups have long called for an immediate drop in the corporate rate. The Senate's willingness to delay the cut by one year helps the score of the bill by raising $150 billion relative to the House bill, but will win few fans among powerful corporations.

Treatment of Other Corporate/Business Items

Let's look at this in table form:

Item

Current Law

House Bill

Senate Bill

C corporations forced onto accrual method

receipts > $5M

receipts > $25M

receipts > $15M

All businesses with inventory forced onto accrual method

no threshold, but see Rev. Procs. 2001-10 and 2002-28

receipts > $25M

receipts > $15M

Forced switch from the completed contract method to percentage of completion for accounting for long-term contracts

receipts > $10M

receipts > $25M

receipts > $15M

requirement to apply Section 263A Unicap rules to inventory

no threshold for producers, $10M in receipts for resellers

receipts > $25M

receipts > $15M

net operating losses

carry back 2 years, forward 20

no carry back, carry forward indefinitely, limited to 90% of taxable income

no carry back, carry forward indefinitely, limited to 90% of taxable income

deduction for net interest expense

unlimited

limited to 30% of EBITDA, 5 year carryover

limited to 30% of "adjusted taxable income), indefinite carryover

Section 179 expense

limited to $500,000

limited to $5 million

limited to $1,000,000

Immediate expensing of assets with life < 20 years

none unless Section 179

for the next five years

for the next five years, then phased out over five years

Entertainment expenses

50% deductible

nondeductible

nondeductible

Section 199 manufacturers deduction

up to 9% of domestic production activities

eliminated

eliminated

Observation

The Senate bill is fairly consistent with the House bill, though businesses will lose many advantages -- availability of the cash method, exceptions to the Unicap rules and percentage-of completion method -- at lower revenue thresholds. In addition, the Senate bill is less generous with the Section 179 deduction, which will become important when 100% expensing sunsets in 2023.

The Senate bill does provide a depreciation break the House bill does not: the depreciable life of residential and nonresidential real property would be reduced from 27.5 and 39 years, respectively, to 25.

International Tax

Current Law

The U.S. currently operates under a deferral system. To illustrate, if a U.S. corporation, in search of greener tax pastures, sets up a subsidiary in a low-tax locale such as Ireland, any income earned by the affiliate in Ireland is not subject to U.S. tax until it is repatriated to the U.S. in the form of a dividend, at which point it will be taxed at rates as high as 35%. As a result, U.S. corporations feels little motivation to repatriate foreign income; this is precisely why there is reported to be as much as $2.5 trillion in assets attributable to U.S. multinational businesses stashed overseas, where it has yet to be subjected to U.S. tax.

House Bill

HR 1 would switch to a territorial system by providing a 100% dividends received deduction to U.S. corporations when amounts are repatriated from foreign subsidiaries. To prevent a windfall to those corporations who currently have cashed overseas that has yet to be taxed, however, a one-time "deemed repatriation" would be imposed, under which the U.S. corporation would pay tax of 14% on any cash stashed overseas and 7% on any illiquid assets.

Senate Bill

The Senate bill would also shift to a territorial regime, while embracing the concept of a deemed repatriation, only with rates of 14,49% on cash and 7.49% on illiquid assets.

Observation

It's worth noting that the House bill originally started with repatriation rates of 12% and 5% before it became necessary to raise those rates to the present 14% and 7% in order generate additional revenue to make the bill fit within the budgeted $1.5 trillion in tax cuts. Similarly, the Senate bill started at rates of 10%/5% before the need for additional revenue arose when the pass-through deduction was increased from 17.4% to 23%.

What comes next?

With the Senate bill passed, the two chambers must now got to conference and iron out any differences detailed above. Once complete, a final bill must continue to meet the two requirements of the budget reconciliation process in order for the GOP to be able to pass its vision of tax reform without a single vote from a Democratic Senator:

The total tax cuts over the first 10 years can't exceed $1.5 trillion, and

The bill cannot add to the budget deficit beyond the ten year window.

As indicated above, the common ground far outweighs the points of contention, meaning the passage of a final tax bill should arrive just in time for Christmas.